What is the best choice of regulatory instruments/tools for Energy Efficiency promotion based on efficiency and effectiveness of reaching policy targets? (Energy Efficiency Certificates versus Central Procurement and others)

[Response by Sanford Berg and Achala Acharya, November 2012. Helpful comments from reviewers are gratefully acknowledged. This write-up draws upon a number of resources, including the IEA Energy Efficiency Governance Handbook (2010) and the International Confederation of Utility Regulators’ A Description of Current Regulatory Practices for the Promotion of Energy Efficiency (2010).]

Introduction:

The renewable energy FAQ on the role of the sector regulator in promoting energy efficiency listed a set of tools available to regulators for promoting demand-side initiatives in support of conservation and EE. While market failures might justify government playing a role in EE, there is also the possibility of government failure, as when energy efficiency initiatives are the result of special interest lobbying that benefit one set of stakeholders but results in cost burdens being met other stakeholders, raising questions of fairness. In addition, the benefits might not exceed the costs of particular EE programs; this possibility raises the question of efficiency. The advantages and disadvantages of incentivizing utilities to make EE investments are addressed in the concluding section.

Realistic targets are essential if programs are to be developed and implemented for reasonable time frames. If targets are too easy to hit, they are unnecessary (and the incentives utilized are likely to be excessive). If the targets are too difficult to hit, the organization actually implementing the program will anticipate failure, and possibly reduce its own efforts. The FAQ on the role of the sector regulator in energy efficiency identified two types of initiatives promoting EE: utility-based EE actions incentivized by the sector regulator and activities promoted by other agencies that might seek advice from the sector regulator. The phases of EE policies, roles of the regulator, and challenges are outlined in the Table below:

Table: Role of the Regulator in Applying Instruments that Promote Energy Efficiency

The Table indicates a number of roles for sector regulators. In addition, the promotion of EE can involve the removal of regulatory barriers to EE:

• Energy tariffs that discourage customer EE investment (such as declining block prices or pricing below marginal cost).
• Incentive structures that encourage energy providers to sell energy rather than invest in cost-effective energy efficiency.
• Institutional bias towards supply-side investments: engineers are trained to build and operate electrical systems.

Energy markets can have pricing distortions: price is administratively set by regulatory bodies subject to political pressures. Excessively low prices tend to reduce the private benefits from investments in energy efficient technology. So customers have less incentive to engage in conservation. In principle, excessively low prices provide a positive incentive for the distribution utility to promote conservation and energy efficiency. If the price is less than marginal cost, a reduction in consumption increases the utility’s net cash flow. However, EE has up-front costs as opposed to “costless” rolling black-outs (reduced reliability), brown-outs (intentional drops in voltage to reduce load), and delays in expanding the distribution network. If there are no penalties for the latter developments, managers may choose not to add EE initiatives to their current responsibilities unless there are incentives to do so.

Instruments

There are two broad sets of instruments for reducing emissions or promoting EE; setting prices or quantities. The basic issue involves how to deal with the uncertainty regarding compliance costs for reducing emissions (or for reducing kWh consumption). When a price is set, as in the form of a tax on emissions, utilities will reduce emissions up to the point where the additional costs of compliance equals the tax. The utility would not spend money on reducing emissions when it is less expensive to pay the tax. However, the outcome is not known in advance, since policy-makers are not sure about the cost of compliance. On the other hand, quantity controls (limiting emissions by mandating targets) are generally handled via tradable permits or quotas that establish the targets without knowing the marginal cost of meeting the target. Utilities are issued a permit allowing them to emit a particular quantity. The target can be met by reducing their own emissions or from buying “permits” or certificates from utilities that find it relatively inexpensive to meet their targets. Such utilities reduce emissions more than required, and so they have permits they can sell. Thus, the quantity targets are met, but policy-makers do not know the marginal cost of meeting the targets in advance.

In the context of EE, entities adopt specific programs (such as conducting energy audits or mandating particular technologies like compact fluorescent lighting) that reduce electricity consumption. Energy Efficiency Certificates (EECs) involve setting quantity targets for each utility, so the costs of meeting the targets are not known in advance. EECs and procurement programs are briefly summarized below.

Energy Efficiency Certificates (EECs): Also known as White Certificates and Energy Efficiency Credits (EECs), EECs certify the attainment of a certain decrease in energy consumption. These targets imply reductions from some baseline (actual or predicted). Italy, France, and Denmark (in 2005-2006) initiated programs whereby producers or distributors implement EE/conservation projects that reduce energy consumption. If target are not met, there are penalties. The introduction of tradability promotes the least-cost achievement of targets and should stimulate activities by ESCOs. However, Energy Efficiency Certificate programs can involve substantial set-up and transaction costs (developing the system, determining a baseline, and authenticating savings).

EEC programs involve certification schemes that include¹

1. Appointing an independent body for issuing certificates,
2. Clearly defining certificates: measurement, technologies, eligibility, validity, etc.
3. Formulating “rules of the game” (trading, parties, compliance),
4. Establishing a registration system and systems for monitoring and verifying savings,
5. Formulating compliance rules and setting penalties for non-achievement of targets,
6. Organizing the redemption of certificates.

In general, the sector regulator would not be the agency responsible for the measurement and verification of EECs but would be involved in the development of systems—particularly as it impacts utilities and customers. EE has implications for utility load forecasting, program costs, investment planning, and other managerial responsibilities.

Centralized Procurement: Utilities might provide energy conservation initiatives through energy audits and other programs. Alternatively, the delivery of such services might be provided by Energy Service Companies (ESCOs). The same kinds of issues arising for PPAs for renewable energy (supply-side) surround the procurement of EE (demand-side), so they will not be discussed in detail here. Developing comprehensive contracts and verifying performance (by the utility or an ESCO) are two fundamental tasks for the regulator.

Energy Efficiency Governance: The IEA Energy Efficiency Governance Handbook goes into much more detail on the importance of having a coherent system for developing, incentivizing, and evaluating energy efficiency programs. There is much to be learned from experiences in other countries, so networking with other regulators and with agencies within the country represent an important way to avoid repeating the mistakes of others. The Handbook begins with the enabling framework—laws and decrees, strategies and action plans, and funding mechanisms. Each of these elements undergirds a sound framework that ensures citizen input, transparency, and resources. Government programs are seldom self-implementing. Responsible agencies must develop strategies for achieving the objectives stated in the legislation or executive order. In addition, quantitative, time-bound goals or targets should be established to facilitate monitoring. The Handbook proposes guidelines for setting EE targets (p. 40), such as not being excessively ambitious, being underpinned by analysis, reflecting input from stakeholders (consultation), and communicating and documenting targets in a clear manner. Country experiences are also summarized (p. 37).

Specific Energy Efficiency Policies

Since those policies most relevant for sector regulators have already been identified in another FAQ, here we list the policies using the categories presented in the IEA Handbook (Table 3). However, we do not attempt to describe them in any detail.

1. Reduced commercial and non-commercial line losses: To the extent that the utility experiences significant theft and has not optimized its transmission and distribution system, electricity that is produced does not reach consumers who are paying for it. The difference between energy produced and energy sold constitute line losses. Regulatory incentives to reduce line losses represent a strategy for promoting energy efficiency. Of course, the regulator should not micro-manage how the utility reduces these losses, since these involve engineering and economic trade-offs requiring substantial operating information.
   
   Case:In Jamaica, JPS had several areas of Kingston with significant demands but few paying customers. Non-commercial losses (through illegal and unsafe connections) were substantial. After a major initiative (involving local government and the community), poor families were safely connected to the grid and overall consumption fell. Some of that drop can be attributed to conservation activities of households and some due to inability to afford the quantity that had been previously consumed at a zero price.
2. Improvements in Load Patterns: An electricity system with high peak demands relative to base loads will tend to have peaking units that have low capital costs, but high operating costs. When consumers face a uniform price throughout the day, they have no incentive to cut back on consumption during those periods where marginal cost is quite high. Reducing peak demands can lead to lower overall production costs and (possibly) to lower emissions (depending on the configuration of generating units). In some cases, seasonal rates might make sense, since there are no additional metering costs and the seasonal peaks can be shaved. Time-of-use pricing for large users and demand side management programs can shift demand to off-peak periods, potentially improving production efficiency. Because the use of prices involves greater uncertainty about customer responses, direct load control or interruptible rates for industrial customers are sometimes used to improve management confidence in obtaining shifts in demand patterns.“Demand Side Management (DSM) programs refer to actions taken on the customer’s side of the meter to change the amount or timing of energy consumption. Demand Response (DR) is a subset of Demand Side Management. It usually refers to a set of activities to reduce or shift electricity use to improve electric grid reliability, manage electricity costs, and ensure that customers receive signals that encourage load reduction during times when the electricity grid is near its capacity. Emergency Load Response programs are interventions aimed at avoiding shortfalls in energy supply. Usually, the Transmission System Operator (TSO) offers remuneration to particular categories of consumers amenable to planned and unplanned interruptions to their energy supply in order to prevent critical situations in network operations. Demand Side Bidding (DSB) is a mechanism that enables consumers, either directly or through a broker, to participate in the electricity market or in the operation of the system through offers that cause changes in their normal consumption profile.”²Case:South Africa has introduced a Standard Offer (SO) comparable to a Feed-in Tariff (FiT), in that the contract compensates the customer for a pre-determined level of kWH saved (or load curtailed). ESKOM is using this mechanism to address capacity issues. Interruptible rates could be viewed as a tariff substitute for this instrument.Case: In Egypt, one load shedding agreement for 160 MW is in place between the TSO and a large fertilizer company. The Egyptian regulatory authority is preparing a regulatory framework for interruptible contracts, including rules for load shifting, peak shaving, planning of regular and annual maintenance.³
3. Improvements in System Reliability: A utility system that has frequent outages (or rations electricity by limiting service to particular localities—rolling blackouts) causes users to seek alternative sources of energy. Industrial customers can turn to self-generation and residential customers to other (less clean) sources of energy. Self-generation generally means that the industrial or commercial user is unable to take advantage of scale economies (so the cost of the reliability is high). Also, these small units are often far less environmentally benign than those available to the utility. Thus, regulators can promote clean energy and energy efficiency through incentives that promote improvements in service quality (targeting reliability and voltage stability). For systems that are not subject to regular power outages, further improvements in reliability will not have significant energy efficiency impacts, so improvements should only be based on the valuation customers place on reliability.
4. Regulation of metering and billing and other information provided to consumers regarding their consumption:“Energy utilities are generally required to provide information to their existing and potential customers in order to increase their awareness of energy consumption. Such information can include the level of consumption, articulated among different aggregations of hours—in some cases compared with historic consumption, the contemporaneous level of prices or tariffs, and other aspects such as the quantum of greenhouse gases emissions caused by a specific level of energy consumption. This kind of information can be provided to consumers primarily through three channels: through metering, in bills, in displays associated with smart meters and through on-line data access.”⁴For developing countries, bills to residential customers represent the primary communication channel to this group—so it becomes important that utilities design a format and select information and effective messages that are consistent with education levels and cultural norms.Case: The Electricity Regulatory Commission of Jordan is introducing a time-of-use pricing regime under which it will provide each consumer with two bills, one of which is based on a flat tariff with the second based on a time-of-use tariff for its energy consumption. In Egypt, a marketing campaign on electricity bills has been carried out to encourage consumers to use compact fluorescent light bulbs (CFL).⁵
5. Promote Utility Energy Audits: Utilities are in a position to analyze bills and conduct on-premise energy audits to identify areas of saving. Depending on the EE law, regulators could require utilities to undertake costly audit programs; the savings on electricity bills could be shared with the utility—until the audit outlays are recovered. If the audit leads to customer outlays, then customer costs also need to be recovered in the sharing plan for allocating bill savings from investments.⁶The long term impact of effective programs is to delay the construction of new generating units. However, for a utility that is not rationing electricity, if price is greater than marginal operating cost, demand reductions represent lost net revenue. Regulators need to recognize the potential conflicts that can arise from such outcomes. Thus, the energy audit process could be outsourced to ESCOs.Case: In Algeria, mandatory audits have been established for the industrial, tertiary and transport sectors, requiring reporting, preparation of action plans and the appointment of energy managers. Compulsory energy audits are also in place in Tunisia, with a 5 year cycle, for operations consuming more than 1.000 TOE (ton oil equivalent) in industry and more than 500 TOE in both the tertiary and transport sectors.⁷ The sector regulator is in a position to monitor the impacts of subsidies covering 20-50% of EE expenditures, but the program is carried out by a specialized agency: Agence Nationale pour la Maitrise de l’Energie (ANME).
6. Incentivize smart grids:A high tech approach to improving operations and the customer interface involves smart meters and information systems that enable the utility to track system performance in real time. The costs of implementing such systems need to be balanced against the benefits, including the possibility that outlays on other projects might be much more cost effective, particularly in the context of a developing country.Case: In Saudi Arabia, a program for the installation of remotely readable smart meters is under way for commercial and industrial customers and it is planned to be gradually extended to all customers.⁸

These strategies for promoting energy efficiency can improve system operations and are central to a sector regulator’s mission to improve sector performance.

Note that the State might develop grants, subsidies and tax incentives for energy efficiency investments, but these are not generally instruments available to regulators. Similarly, public information campaigns, adding EE to school curricula, developing appliance labeling systems, and creating certification programs for buildings are outside typical regulatory responsibilities.

Regulatory Review of Utility Energy Efficiency Programs

We conclude with some observations about the regulatory review of utilities that provide EE programs. Attention should be given to the strengths and limitations of utilities. The IEA Handbook identifies the advantages and disadvantages of energy providers delivering EE Programs:

Advantages of Utilities:

• ready access to capital (although some state-owned utilities are capital-starved, due to pricing below cost);
• an existing relationship with end users, including billing systems and market data;
• a familiar brand name (which may not be an advantage if performance has been weak in the past—reputations are difficult to change);
• a widespread service and delivery network within their jurisdiction;
• responsible for anticipating and accommodating energy and peak demand growth.

Disadvantages of Utilities:

• overlap in commercial and societal interests may be small;
• potential disincentive to incur costs, increase prices or reduce sales.

State-owned and privately-owned utilities may place different weights on the bottom line (or the return on investment), but managers for both types of service providers will need to be brought into discussions of alternative programs early in the process. Of course, regulators need to ask whether utilities they are monitoring have the capacity to successfully implement EE programs and projects. If utilities have little experience in the field, then “starting small” makes sense, so that the utility’s capacity to implement programs grows over time. The IEA Handbook (Box 12) identifies nine key points for ensuring effective EE through utilities:

1. Use clear criteria for considering whether energy providers should act as EE implementers.
2. Utilities can be particularly effective when delivering EE that has resource value.
3. Government or regulators must establish the conditions that enable utilities to implement EE.
4. Downstream utilities may be better positioned to deliver energy efficiency.
5. Avoid complexity and simplify procedures whenever possible.
6. Take advantage of the commercial acumen of utilities (where it exists), within a portfolio framework.
7. Maintain oversight arrangements to guarantee the cost-effectiveness of results.
8. Apportion institutional responsibilities to governmental and regulatory actors.
9. Consider System Public Benefit or Wires Charges, as these are an effective way to fund energy efficiency, regardless of who implements the programs.

Given the appropriate legal enabling framework (driven by national objectives), the benefits and costs of EE policies can be estimated by infrastructure professionals. Nations have a wide range of options for addressing EE issues. It is up to the regulator to provide input into the policy-making process and then to implement national policies in ways that improve sector performance.

Footnotes

1. “White Certificates: Concept and Market Experiences” EuroWhiteCert Project, www.eurowhitecert.org . The write-up lists fourteen issues that would need to be addressed in such a system and describes the experience in six European nations.
2. ICER pg. 35
3. ICER pg. 142
4. ICER pg. 33
5. ICER pg. 121
6. “Energy audit allows a systematic approach for decision-making in the area of energy management and represents an effective tool in defining and pursuing comprehensive energy management program. Audits are scalable, and can be applied to large and small users, domestic and business. Audits consists of the verification, monitoring and analysis of energy use, including submission of technical reports containing recommendations for improving energy efficiency, based on cost-benefit analysis, and an action plan to implement them. The audit is aimed at identifying all of the energy streams present in a facility and quantifying energy usage according to its discrete functions. The audit facilitates subsequent measures that can be undertaken, including the reduction of energy consumption, fuel switching, and load management.” ICER pg. 32
7. ICER pg. 97
8. ICER pg. 135

References

IEA Energy Efficiency Governance Handbook (2010).
International Energy Agency

A Description of Current Regulatory Practices for the Promotion of Energy Efficiency
June 21 2010, 1-180.
International Confederation of Utility Regulators

Market Barriers to Energy Efficiency: A Critical Reappraisal of the Rationale for Public Policies to Promote Energy Efficiency
Energy & Environment Division Lawrence Berkeley National Laboratory, University of California Berkeley, California 94720. March 1996.
Eto, W. H.and Golove W.H.

Financing Energy Efficiency: Lessons from Brazil, China India and Beyond.
Washington DC: The International Bank for Reconstruction and Development / The World Bank, 2008.
Taylor R.P, Govindarajalu C., Levin J., Meyer A.S., Ward W. A.

White Certificates: Concept and Market Experiences
EuroWhiteCert Project, 1-6.

Around the World: Lessons Learned in 49 Countries
ESCOs, Fairmont Press, 2009, viii-377.
Hansen, Shirley J., Pierre Langlois, Paolo Bertoldi